A deep dive into Inflation

Believe it or not, a vada pav used to cost about Rs 5 in the late 90s, a quick snack relished by all walks of society alike. Today that same vada pav costs Rs 15.

What caused this price increase?

Well, this price increase is called inflation.

Inflation is an economic term that describes the rate at which the general level of prices for goods and services is rising.

It is usually expressed as a %, indicating the rate at which the prices of goods and services are expected to increase.

For better context, the current inflation rate in India at the time of this article is about 5%. This means that the cost of a good or service is expected to increase by 5% in the following year, as per the current economy.

Without diving too much into the calculation, since it depends on a host of factors, the inflation rate is typically measured by what is called a Consumer Price Index (CPI), which tracks the cost of a basket of goods and services over time.

The inflation rate is derived from this cost tracking.

But why does this happen?

Why does the cost of our vada pavs and everything else increase?

For this, we will have to understand the types of inflation.

Broadly and simply, there are three ways inflation occurs.

Demand-pull inflation occurs when there is an increase in consumer demand, more than the supply. A great example is during seasons of festivals when the demand increases substantially, driving up the prices of things.

Cost-push, on the other hand, occurs when production costs increase and businesses have to recover these increased costs by passing on the burden to the consumer and increasing prices, to continue a sustained profit.

This typically occurs when wages increase, or cost of materials and supplies go up. The third type is built-in inflation when workers demand higher wages to keep up with the increased costs of living, in turn leading to higher prices, and can lead to a spiral.

So is inflation bad?

Well, it is when the following extremes happen:

When the inflation becomes too high, it indicates that the demand outweighs the supply. This would mean that there is excessive money floating in the economy enough to exhaust the supply, while not enough supply is being met with the demand.

On the flip side, low inflation, called deflation, is the other side of this double-edged sword, indicating an economic stagnation, wherein the economy is not growing at the rate expected.

This could show itself in the form of reduced production or unemployment.

But here's the thing. Inflation is not inherently bad.

In fact, one could rightful argue that it is essential to a growing economy.

Inflation in the right amount could signal a healthy economy where there is increasing demand, which is leading to a competitive market, pulling the prices up.

Here is why you would still want the prices of things to rise.

If you purchased a property for 20 lakhs today, you would want the prices to go up in the next 15-20 years, wouldn’t you?

Similarly with all your investments. Even your income.

We would want all of these to increase over time.

This increase in income boosts consumption of goods and services as everyone is now able to afford more goods and services.

This enables companies to expand production, hire more employees, thus increasing employment and therefore income.

So there is a certain amount of inflation that that is not only beneficial but rather essential for a healthy economy to grow.

What is this healthy rate of inflation?

Since the calcualtion of inflation involves a lot of considerations and variables is it tricky to have an absolute inflation target %. However, the RBI’s mandated target range for CPI inflation is 2% to 6%, with a medium-term goal of 4%. This target is designed to stabilize prices in a rapidly growing economy across different sectors and regions.

While inflation is a phenomenon influenced by numerous variables, understanding it is crucial for making informed personal and financial decisions. By recognizing the causes and effects of inflation and how it is managed, young Indians like you can better navigate their economic environment and have a better understadning of the health of the economy.

Stay tuned, until next time!

---

FAQs about Inflation:

Here are seven FAQs based on your article about inflation, tailored to enhance understanding and delve deeper into topics not explicitly detailed in the text:

1. What is the Consumer Price Index (CPI) and how is it calculated?

- The Consumer Price Index (CPI) measures changes in the price level of a weighted average market basket of consumer goods and services purchased by households. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.

Changes in the CPI are used to assess price changes associated with the cost of living.

2. How does festival season affect inflation in India specifically?

- During festival seasons in India, demand for goods and services increases significantly as people engage in more shopping and festivities. This heightened demand can outstrip supply, leading to demand-pull inflation where prices rise because the amount of goods available isn't sufficient to meet consumer demand.

3. Can you explain how wage increases lead to cost-push inflation?

- Wage increases can lead to cost-push inflation when businesses face higher labor costs and pass these costs onto consumers by raising prices. As wages rise, the overall cost of production increases, making goods and services more expensive, which contributes to overall inflation.

4. What are some indicators of economic stagnation that might accompany low inflation or deflation?

- Economic stagnation in the context of low inflation or deflation might be indicated by reduced consumer spending, high unemployment rates, lower income growth, and decreased business investment. This stagnation reflects an economy operating below its potential.

5. Why is a small amount of inflation considered better than deflation?

- A small amount of inflation is considered better than deflation because it encourages consumers and businesses to spend and invest sooner rather than later, fostering economic growth. Deflation can lead to a decrease in consumer spending and business investment as the value of money increases over time, potentially leading to an economic downturn.

6. How does the Reserve Bank of India (RBI) use monetary policy to control inflation?

- The RBI uses monetary policy tools like adjusting repo rates, reverse repo rates, and cash reserve ratios to control money supply and inflation. For example, by raising interest rates, the RBI can reduce the money supply, curbing excessive spending and inflation; conversely, lowering interest rates can increase spending and investment.

7. What could be the consequences of inflation rates rising above the RBI's target range?

- If inflation rates rise above the RBI’s target range (2% to 6%), it could lead to reduced purchasing power, higher costs of living, and potential wage-price spirals, which can destabilize the economy. It may also necessitate stringent monetary measures from the RBI, possibly

leading to slowed economic growth.